Market Insights

Another leg lower in the Turkish lira overnight, dragging down with it a whole bunch of other EM currencies. Measures announced by the Central Bank stopped the rot briefly, and USD/TRY now sits in the middle of a delightful 6.40-7.20 range. For comparison, in January the entire month’s range was only 3.76-3.95: we have done four times that in less than 24 hours.

The scores on the doors show:

Last week was the worst for the Turkish Lira since 23rd February 2001 – which itself came only after the central bank stopped defending the soft lira peg that was put into place after the IMF bailout. Back then, the central bank lost one-sixth of its FX reserves and interest rates hit 3,000%.

The sell-off in the South African Rand was the worst since 15th October 2008 – right in the heat of the financial crisis, when USD/ZAR moved from 9.07 to 10.74. Last night was Sunday twilight liquidity but USD/ZAR moved from 14.20 to almost 15.60 and back again

So we are seeing the kinds of moves that accompanied very serious financial market stress – and yet, aside from Turkey’s problems, there really isn’t that much stress around.

In any case, is this really that big of a crisis for an Emerging Market? Bloomberg burbled this chart to claim that no, it’s not:

To which we would respond:

August 2018 ain’t over yet folks!

Turkey 2001 occurred when a peg was abandoned, yet we have had something similar from a free-floating ccy

It’s of a similar magnitude to Russia 1998 which, er, led directly to the LTCM crisis

The last point is the big one. These big moves are happening because of systemic market leverage. The system itself is unstable. Erdogan isn’t to blame for that.

Commentary on Turkey so far simply says:

This was obvious; an accident just waiting to happen.

Erdogan engineered this, he interfered with the central bank, that’s why it was so bad.

Turkey needs this to reverse direction. Markets force change.

It’s August so it’s illiquid anyway.

…and the impact on other markets should be limited. The ECB is ready to help European banks and they’re already doing QE; the Fed won’t care; the VIX hasn’t budged anyway.

Why don’t we want to see the truth?

QE chopped off the downside of any distribution. Passive money removed forward-looking judgment. The future would look like the past.

But now QE is stopping. Passive money created a tracking mechanism that falls apart when prices shift dramatically. The future hits us in the face suddenly.

We here at BlondeMoney keep being told that this is all too obvious. That when something happens it will be something unexpected.

We disagree. As we said in June, “we now have Black Swan price action on the evidence of White Swans” and “the real Black Swan will be an event that sends the pendulum into unstoppable overdrive and will be a combination of:
1) positioning and pricing are the exact opposite of where they should be due to a new – or previously ignored – risk
2) flows shift
3) positions tracking passive products like ETFs are forced to liquidate”

Turkey certainly delivered us 2 and a hint of 1 and 3. Here is the iShares Turkey MSCI ETF compared to its “intrinsic value” during the course of Friday:

As you can see there are some large deviations between the two, despite the website for this ETF showing only a Premium of 0.59% “as of August 10”. That’s only derived from its end of day NAV, but as we know the joy of ETFs is that they can be traded intra-day. This one is quoted in USD. But all of its holdings are listed in Turkey.

And that’s before we even go into how on earth an “intrinsic value” can be calculated when liquidity means the price on the screen for stocks or bonds or currencies is not necessarily the price that they can be traded for in reality.

It’s no wonder that we are getting wild price moves when liquidity is so misunderstood. Here’s 1 month USD/TRY implied volatility. It’s now higher than it was during the financial crisis:

We need to look at Turkey with fresh eyes. It’s not about the risk itself, worrying as that might be if you have exposure to Turkey. It is about how a market can spin wildly out of control when the entire system is as unstable as it now is.

We continue to believe that Brexit will be the next big shoe to drop:
1. A previously ignored risk
2. Flows shift – note Financial News reporting today on fund managers triggering contingency plans for a No Deal. ‘Allianz is working out a strategy to ensure it can continue to do business in the UK in the absence of any transitional arrangement. CEO Andreas Uterman said: “I never thought it would come to this”‘
3. Positions

Only 3 is yet to fall into place. We expect that to come in September.

Today I learnt of the passing of the man who taught me all about the markets. And a good few things about life too. Forgive me then for a moment to remember him.

Armed with a Classics degree from Cambridge, a dramatic flourish of melancholy from Northern Ireland, and a handy bit of know-how from amateur boxing, Ed had charisma, knowledge and tenacity in spades. We met just after September 11th 2001, at Merrill Lynch. I had just started as a graduate, plunged into the foreign exchange desk in the midst of recession, and the omnipresent Bin-Laden-induced threat of War. Ed had that memory seared upon him more than most, having been on an introductory trip to the ML NYC office and seeing the second plane crash into the towers.

During the mayhem, he revealed his true calling: teaching. He was the only person who sat down with me to give me a structure to this new crazy day that kicked off at 7am. “Write down the opening levels when you walk in”, he urged, “and a few bullet points from the morning meeting… that will get you through the day without looking like an arse”.

Looking like an arse was the usual state of affairs for a graduate trainee. He did his best to help me, not only to understand what was going on, but also to get used to an environment where failure meant money losses or even job losses. That meant no kid gloves, for which I am eternally grateful. You’ve never really experienced humiliation until the dealing desk turns round and looks at you when you take your first phone trade, and instead of “Mine” or “Yours”, you meekly tell the trader “His?”.

No-one laughed more than Ed, who thumped me on the back and told me not to f**k it up next time.

Fortunately he didn’t let me sink or swim too far on my own in those early days. He would step in if I found myself out of my depth, but never by patronising me. He would encourage me if I did something well, but never by promoting arrogance. A few months in, he called into the desk for a market round-up. I seriously reeled off some information about non-farm payrolls, technical levels and the Euro hitting parity against the Dollar. Silence. He chuckled. One of his excellent cigarette-and-alcohol-stained chuckles. I braced for the inevitable criticism. He simply said, “F**k me, you almost sound like a real salesperson, praise the f**king Lord we are making something of you my girl!”.

Having passed the test, I could join the various client events and drinking sessions in our nearest pub, the Viaduct. (Why they literally built an investment bank on top of a pub, I’ll never know). I was part of the gang. It didn’t matter that I had a cleavage, Ed just cared that I had a brain. For a team of 40 people with only 4 women in it, this was a blessed relief.

He and his Northern Irish buddy, the Ballymena Academy boys, were the only men who didn’t treat me any differently because I was a woman. They watched out for me. They wanted me to succeed.

In latter years Ed would tell me how proud he was of the part he played in my success. He could never, unfortunately, be happy with his own.

He was the cleverest man I ever worked with. The most charismatic with clients. The smartest about trades. The most humble. The most honest. Someone who I believed in as much as he believed in me. If only he could have believed more in himself.

The demons chase us all. If we are lucky, we can escape them or at least shove them where they haunt us least. For the man we called Little Old Edmundo, it proved an ongoing battle that ultimately ended only in the harshest form of peace.

He was no angel. The greatest teachers rarely are. It takes an understanding of both darkness and light to teach someone how to navigate the path ahead. We argued, we cried, we shouted, we hugged, we laughed. We learned. And what could be a greater gift in life than that?

TM will survive unless angry Brexiteer and Remainer MPs number more than half the party (159 MPs). That’s unlikely. Instead they will seek to frustrate the Chequers “Brexit In Name Only” deal via parliament. Blow-up of No Deal still on track for Q3.

(Also, here is a reminder of David Davis’s failed 2005 leadership bid…)

Silence so far from the other big Brexit beasts, specifically BoJo and Gove. DD has already announced he wouldn’t be running for leader (although things can change), so the Brexiteers need a candidate to rally round. JRM would be the obvious choice. He wrote in the Telegraph today that he would be voting against the Chequers Plan.

But he is a divisive figure. There are Brexiteer MPs for whom JRM goes too far, and he’s certainly too far for the pragmatists/Remainers. They would fear the membership could vote for him if he made it into the final round of the leadership contest. And so they would prevent that contest ever taking place.

If the Leader of the Conservative Party doesn’t resign then 15% of Tory MPs must submit letters to the backbench 1922 committee to bring a Vote of No Confidence against her. With up to 60 MPs in Jacob’s Brexit-loving European Research Group, there’s more than enough to get 48 letters to go in. But TM would need 159 MPs (half the parliamentary Conservative party) to be forced out.

If TM survives a No Confidence vote, they don’t get to call another one against her for 12 months. If she doesn’t, then it goes to the ballot of MPs to pick 2 choices, which then go to the party membership.

We then get weeks if not months of the UK being leader-less as the clock ticks down. The March 2019 date could of course be delayed, but it’s not clear the public would be happy about any of this. They have had 2 years to get their Brexit sh1t together, after all. Would the general public ever forgive the Conservative Party for this abnegation of duty?

Not to mention that the leader would ultimately be chosen by only ~125,000 people. Could the general public stomach that, in our pan-global era of foot-stamping demands for democracy?

This has always been the calculus behind those who may not like TM but see no other alternative. Try and take her down and be branded saboteurs not just of Brexit but of Britain. At least half the party would not want to take that risk, therefore she could survive a no confidence vote; therefore no point in bringing one.

Unless you’re an ideologue who wants to stamp on history that you didn’t agree with any of this: the hardcore Brexiteers and Remainers will still be interested in bringing a vote. But together they are no more than half the Party.

And so we are in a stalemate

Unless public opinion changes. As we wrote on Friday, people are not all that happy with the Brexit process, and now we have England in the semi-finals of the World Cup along with the biggest heatwave for decades. The general public right now would simply say “is David Davis our new left back? Pass me a beer mate”. Theresa May is consistently out-polling Corbyn as best candidate for PM, although a third of the country aren’t sure who would be best (or more likely don’t give a ….).

Today:

TM meets the Conservative Backbencher committee. No doubt this will be tough but will the MPs be able to agree amongst themselves? If they bring the vote of no confidence and she wins it, they can’t challenge her again for 12 months. Better instead to try to do battle in parliament on the detail of the policy.

The PM’s Chief of Staff, Gavin Barwell, has invited Labour MPs to a briefing on the Chequers deal today at 2.45-3.30pm. If you can’t rely on your own side, threaten them with numbers from the other.

In conclusion:

The Chequers deal has annoyed both Brexiteers and Remainers. Therefore, it’s the least worst solution.

For Conservatives, neither side has the numbers to replace the PM with one of their own. There is (not yet) a clear new rallying uniting figure.

For Labour, they can let the Tories tear themselves apart over Europe (again), but they have their own divisions

Everyone is waiting to cover their own back and emerge victorious from the ensuing mayhem. That means no-one lights the fire, they wait until afterwards to blame someone else for starting it

GBP is therefore understandably unmoved. Not to mention that our old friends PermaQE and PassiveMoneyMerryGoRound mean that unquantifiable risks are going under the radar. If TM survives the next 24 hours without any big resignations then she stays. We move forward with Brexit In Name Only, leaving the antagonists on either side who despise that outcome with the only option: go for No Deal. We continue to believe this will come into full relief in October as increasingly desperate Remainers and Brexiteers go for broke. At which point GBP assets should contain a significant risk premium. GBP/USD can go from 1.3000 to 1.4500 before that happens.

We here at BlondeMoney try to neither be optimistic fools nor fatalistic doom-mongers. Either could garner us more headlines but neither is useful in a world of cold-headed investment decisions. You know by now what’s going to cause the next crisis, so how about a dose of good cheer. It’s always darkest before the dawn.

1 Euphoric Equities

The Nasdaq hit a new all-time high and the FANGs are back baby yeah! Here’s the FANG+ index, on which you can trade futures and options, which just about says it all:

The rally was allegedly due to Goldmans upgrading Tech to overweight; we prefer to think of it as Momentum Is The New Safe Haven. So let’s not mistake this euphoria for an all-round “coast is clear” risk-on rally.

2 EM Excited

It will look like that, however, because we are now all so embedded in the game of prices telling us the story. Emerging Markets might just get the buy-the-dip boost they’re looking for, with the astonishing timing that Argentina has been upgraded back into EM status, from mere Frontier, by MSCI. It’s been in the Frontier for almost a decade and despite its recent woes, MSCI still decided to grant it the full-on emerging market accolade. Where it goes from here will be a fascinating test of our hypothesis: inclusion into an index creates a full-on demand for a country’s assets from the passive index-trackers. Will their flows dominate the active discretionary guys who still fear for Argentina’s health?

Even more excitingly for our hypothesis, MSCI have retained the caveat that they can kick Argentina out again:

‘However, in light of the most recent events impacting the country’s foreign exchange situation, MSCI also clarifies that it would review its reclassification decision were the Argentinian authorities to introduce any sort of market accessibility restrictions, such as capital or foreign exchange controls.’

If that were to happen, then the passive outflows would join in with active outflows, creating an automatic increase in selling on assets already under pressure. Just the kind of feedback loop we hypothesize that passive investments embed into the system.

3 ECB Easing

Our favourite Irish farmer-investor, @LorcanRK, flagged up the key points from the ECB officials’ leaked story to Bloomberg yesterday. The ECB “could consider relaxing the rules on buying” for its reinvestments. As they have a 3 month autopilot right now, this means they could pause and build up a warchest of cash before plunging it back into the market. It certainly gives them flexibility to smooth out any wobbles in the market once they pull back from QE proper. And – Draghi must love this – it could be done any time, without a monetary policy meeting. No wonder Mario called this “an important decision… not a marginal one at all“. It’s his get-out-of-jail free card as he goes into his final innings as President. But it also means some permaQE could be a little bit more “perma” than we first thought.

4 Brexit Back In Its Box

These parliamentary votes of the past two weeks were supposed to deliver high drama. Government defeats, battles, bish bash bosh. In the end, neither Brexiteer nor Remainer rebelled, the government persists, and the boil has yet to be lanced. Is it possible now that Theresa, like The Donald, has become an accidental master of three-dimensional political chess? That the UK will end up with the ideal negotiating outcome where nobody is pleased but those displeased are too divided to do anything about it? If so, then market expectations of a muddle through will be the right one.

This chimes in with the general euphoria we have so far described. It’s a funny kind of euphoria; the kind that comes from the absence of dark, rather than the presence of light.

BlondeMoney CEO and founder Helen Thomas has been interviewed by LiquidiTV about what she believes is the biggest vulnerability in the market.

Below is her interview, although should you want the PDF version you can find that by clicking here.

If you have any questions about the follow, please email us.

Normally we have our new segment ‘getting to know the industry’ here, but thanks to a fascinating markets conversation with a good friend (whom we met through our last hedge fund), we decided to hear her thoughts on the catalyst for an coming financial crisis i.e. ETFs.

Helen Thomas is one of our regular experts for our fortnightly question and is the Founder of BlondeMoney, a macroeconomic consultancy and research specialist company she launched in 2017. Having graduated from Oxford, she worked at Merrills in FX, was a partner at a Global Macro hedge fund and advised the Chancellor of the Exchequer George Osborne during that little financial crisis we had in 2007/2008. Currently she is a board member of the CFA, UK and a few years back was the lead researcher for the book “Masters of Nothing”.

What do you think the issue is with ETFs?

ETFs were a great idea. They combined the investment into a fund with the ability to trade it at any time on an exchange. Instead of buying 500 stocks in the S&P, you could buy the SPY ETF, which closely tracks the performance of all those stocks. Same returns, but cheaper and more efficient; what’s not to like? The reality is that they contain a design flaw. The tracking process comes about because market makers arbitrage away differences in price, between the underlying and the ETF. If they deviate, there should be a risk-free return because they’re the same thing, right? But, arbitrage only works when there is liquidity. And the liquidity in an ETF is dependant on the market makers and their creation agents, the APs (Authorised Participants). They aren’t obligated to make a price, and if it’s too hard to get hold of, say, a high yield bond, then they step away from pricing, say, the HYG ETF. It’s nothing to do with Blackrock or Vanguard; they’re just the shop front. If you go in to buy some chewing gum, it won’t be there if the suppliers stop delivering.

What alarms you about the current situation in the ETF market?

In 2007, CDOs equated to one-fifth of the market capitalisation of the S&P500. The ETF market, at 6 trillion, is now of a similar size. The ETF market is now just too unwieldy. The hedging process that allows the APs to provide ETFs means that their flows are dominating the market: they’re all the same way, all at the same time. The hedging is usually done automatically, so the orders hit the market in milliseconds of receiving the risk. The hedging process relies on correlation. Even Latin American equity ETFs, such as the ILF, have a 70% correlation with the S&P500. That means you can clear 70% of the risk immediately by trading an S&P500 future. Or, why not use the SPY ETF? Yes, ETFs are used to hedge ETFs.

Managing all of this risk are the Delta One trading desks of banks and brokers. They can make decisions on whether to hedge the remaining 30% of that ILF flow, for example. If they choose not to, they are taking prop risk. Banks are taking on hidden leverage on the back of ETF flows. Oh, and their capital charge is lower if the risk sits on the Delta One desk, because those positions are for ‘market making purposes’.

Hidden leverage and unpredictable liquidity are the hallmarks of every financial crisis we have ever seen.

How do you see markets unfolding down the track if things don’t change with ETFs?

So ETFs depend upon functional liquid markets. We are now at a turning point when central banks are turning off the Perma-QE taps. Liquidity, having been pumped in, is being sucked out. The virtuous circle where QE drove money into passive investments which compressed credit spreads, lowered volatility, and led money back into risky assets – that’s about to turn into a vicious one. We have already seen the tremors. The “Volmageddon” of February has set the process in motion. Volatility begets volatility as it feeds into risk models of long-term money managers as well as option delta hedgers. We are seeing drive-bys in market after market: Facebook, Russia, Argentina, Turkey, and now Italy. Everyone has to adjust their exposure to risk. Which changes the price of risky assets. Which is used to calculate risk. And so on.

There are no macro narratives now, only the unwind of an unstable market structure.